April 29, 2024 – What began as a robust merger market, with North American M&A deal announcements averaging twenty per month in the first quarter of this year, slowed to a snail’s pace in April, with just nine transactions struck in a spring slowdown.
Despite a choppy equity market, steadily rising bond yields, and cooling interest rate cut expectations, M&A activity bounced back in April, with twenty public mergers announced in North America totalling more than $90 billion in aggregate value. Deal activity this month has averaged nearly one per trading day, feeding an extremely active pipeline for merger arbitrageurs and deal junkies alike. In addition, of the twenty deals announced this month, fourteen are deemed “investment grade” by the merger arbitrage team at Accelerate, leaving an attractive investment universe for yield-seeking allocators and more than a sufficient selection to sustain diversified merger arbitrage portfolios.
Furthermore, a significant number of mergers closed in April, with 17 tie-ups consummated. Eight deals alone closed on April 1st, leading arbitrageurs seeking to redeploy capital.
With capital recycling activity moving at a robust pace, as new merger arbitrage investments are funded with capital from recently closed deals, arbitrageurs are confronting a mixed investment environment.
On one hand, there is “lots to do”, with new transactions being announced seemingly on a daily basis. In addition, merger arbitrage spreads are wide and yields are generally attractive, with the average deal yielding more than 13%, comparing favourably to the 8.2% yield offered by junk bonds.
Source: Accelerate
However, all is not rosy in merger arb land. Just as the average junk bond’s yield of 8.2% can be challenging to capture, given the occasional bond default, the attractive average arbitrage yield of 13.7% can be difficult to capture due to deal terminations and delays, which can either cause a capital loss or a yield compression for an investor.
The Wrath of Khan
In the 1982 science fiction film Star Trek II: The Wrath of Khan, the hero, Captain Kirk, along with the crew of the starship USS Enterprise, faces an antagonist, the genetically engineered tyrant Khan Noonien Singh. Khan blames Kirk for marooning him and his followers on a desolate planet, that, after a series of disasters, becomes a harsh wasteland.
Khan escapes from the planet and comes across the USS Reliant, commandeering it to pursue his revenge. He learns of the Genesis Device, a terraforming tool capable of creating life from lifelessness, which he plans to use as a weapon. A climactic battle occurs in the Mutara Nebula, where strategy and sacrifice come into play, leading to a dramatic and emotional conclusion of the conflict. While Kirk and his allies prevailed over the nefarious Khan, it was not without taking a significant loss, including the death of their friend and ally, Captain Spock.
On their investment journey, our hero arbitrageurs face their own antagonist, namely the Federal Trade Commission (FTC) and its inexperienced and overzealous Chair, Lina Khan.
The Khan-helmed FTC has been on an antitrust rampage, leading to a record level of deal challenges and so-called “second requests,” in which the regulator delays a merger’s consummation to demand more information from the companies. While the FTC has sued to block far more deals recently, its track record has been atrocious, as it has lost nearly every case, including high profile merger challenges of the Activision/Microsoft and Horizon Therapeutics/Amgen transactions (which went on to close successfully).
Antitrust activity hit a new milestone in absurdity this month, with the FTC challenging the merger between fashion houses Tapestry and Capri, whose proposed merger would result in a 5% global market share (compared to nearly 20% for the global market leader in luxury, LVMH). Given the fashion industry’s highly competitive and dynamic nature, a merger has never before been challenged in the sector.
According to the Wall Street Journal’s Editorial Board, “the Federal Trade Commission hits comedic heights in finding a threat to competition in luxury handbags,” adding, “the FTC pulls the old antitrust trick of redefining the luxury market to discover competitive harm. The agency claims the merger will harm competition in the “accessible luxury” and “affordable” handbag market. The agency describes handbags that retail for several hundred dollars as “affordable,” which they may be for antitrust attorneys in Washington. Most middle-class Americans would consider them a genuine luxury.”
The aggressive nature of the merger challenge lies in the FTC’s novel theory of harm on the global market for retail workers, in addition to an extremely narrow market definition in which the regulator theorizes that the brands Coach, Kate Spade, and Michael Kors will create a monopoly in the “accessible luxury” handbag market.
In any event, the WSJ Editorial Board continues its criticism of the FTC, stating, “It’s hard not to chuckle at the Federal Trade Commission’s lawsuit last week seeking to block luxury fashion firms Tapestry and Capri from merging in the name of protecting America’s working class,” concluding that, “there’s no legal or economic logic to the Khan FTC’s antitrust policy other than that the only good merger is a dead merger.”
While the FTC’s reputation as a credible regulator plumbs new lows, the market rolled its collective eyes at the announcement of another dubious merger challenge. Under any previous FTC in recent memory, the Capri/Tapestry merger would have sailed through the approval process, as the deal did in China, Europe, Japan, and other antitrust reviews worldwide.
According to brokerage firm WallachBeth, historically, the average number of deals that had a second request for information from the antitrust regulator was 15-25%. Currently, that figure is nearly 2-3x higher, with approximately 40-45% of mergers getting tripped up in a second request from the FTC or the U.S. Department of Justice.
Additionally, on average, 1-2% of deals have been challenged by the U.S. antitrust regulator. Currently, that figure stands at more than 10% of mergers.
It is the wrath of Khan, indeed.
The market has adjusted to the reality of an overly intrusive FTC by repricing merger arbitrage spreads wider. Presently, the implied probability of the average U.S. public M&A closing stands at 75%, compared to the average closing rate of 94% (going back to 2011). In addition, corporate executives and boards of directors have adjusted their merger strategies, choosing lower-risk consolidation opportunities, aiming not to get caught in the trap of the antitrust regulators.
Source: Accelerate
In any event, risk arbitrageurs need to stick handle through the current M&A market with an extra level of care and caution. While merger activity is robust, risks and traps abound. Arbitrageurs need to account for additional scrutiny and challenges from the antitrust gatekeepers, leading to increased volatility and longer timeframes for some mergers to close.
Those investors who are experienced and skilled enough to successfully navigate a highly active but more uncertain M&A environment will be richly rewarded with attractive, uncorrelated investment returns. In addition, a near-term catalyst exists via the upcoming presidential election. If Donald Trump were to win the election in November, the FTC’s ambitions will likely be harshly curtailed, resulting in a potential “return to normal” regulatory environment and a bounce back in merger arbitrage spreads.
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.
